Moral Hazards in Life Insurance

Life insurance is a contract between an individual and an insurance company that pays a stated amount of money if the covered person passes away during the term of the policy. When you purchase life insurance, you must go through several underwriting procedures including filling out an application and submitting to a physical exam. One risk underwriters look out for is what is called moral hazards.

Moral hazard means the likelihood that a client's behavior will change as a result of purchasing a life insurance policy and that change will increase the chance of a loss. Life insurance companies look to ensure that the act of purchasing life insurance does not make it more likely for someone to end their own life or the life of another.

The phrase "worth more dead than alive" is a reference to how a person's finances can create a moral hazard. If an insurance company allows an individual to purchase much more insurance than his income, the individual becomes a greater moral hazard. Insurance companies try to determine if someone is in or about to go through bankruptcy. An applicant's financial situation plays a large part in underwriting and determining the potential of a moral hazard being created by offering a policy or too large a policy. Insurance companies place strict limits on what percentage of income an individual can purchase life insurance for and have underwriting guidelines to review if the applicant is in poor financial condition.

The owner of a life insurance policy is the only person with the ability to make changes, including the beneficiary and amount of the policy. The ownership of a life insurance policy is important to the review and can easily result in a moral hazard. Typically, someone must have an insurable interest in another person to buy life insurance on that person. This means the person buying the policy would have to sustain a financial loss if the insured were to pass away. Spouses, parents and children fall into this category of need because of the financial burden their death can cause. However, you cannot purchase life insurance on a random person and be the owner of the policy. It typically is best for the insured also to be the owner as long as that person is an adult.

Insurance companies also review through underwriting questions and medical history whether someone is in a safe mental state to purchase life insurance. If someone has been treated recently or frequently for depression, bipolar disorder or several other mental ailments, the insurance company might deny coverage.